Long-Term Treasuries: How Low Can Yields Go?

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Includes: TLT
by: Eric Parnell, CFA

Long-Term U.S. Treasury markets are back in rally mode. With uncertainty running high given the deteriorating situation in Europe and a stock market that has been in sharp decline throughout the month of May, investors are clamoring for the relative safety of U.S. Treasury debt. And nowhere has the benefit been more pronounced than at the long end of the curve, which has rallied by +6% for the month to date. But with yields already near historical lows, this latest advance raises the following question: how much lower can Treasury yields go? Depending on how events play out in global markets in the coming months, potentially quite a bit.

Understandably, some investors are uneasy about the outlook for the Treasury market with the end of the Fed's Operation Twist stimulus program looming in June. But the good news is that the Treasury market has historically performed exceptionally well once Fed stimulus programs have ended. For although the Treasury market will lose what has amounted to $400 billion in demand from the Fed, it will likely more than make up the difference from the $3.7 trillion that has already been pouring out of the stock market, which since the beginning of the crisis has performed dismally once past Fed stimulus has gone away. This money will be looking for a safe haven, and the U.S. Treasury market, while far from perfect, remains an ideal destination.

Looking ahead to the end of Operation Twist in June, it is likely that the Treasury market will at minimum hold steady if not incrementally rise into the summer. Using the iShares 20+ Year U.S. Treasury Bond ETF (NYSEARCA:TLT) as a barometer, gains are not likely to be as robust relative to previous post stimulus phases, as the Treasury market did not sell off as much during the Fed's latest program. But with this being said, if global economic conditions deteriorate into recession and/or the situation in Europe descends into crisis, the potential upside in safe haven Long-Term U.S. Treasuries could be far more pronounced than expected.

So exactly how low could we see Long-Term Treasury yields fall going forward? A useful gauge in assessing potential yield levels is the previous low in the Treasury market. This occurred on December 18, 2008 in the immediate aftermath of the outbreak of the financial crisis. At that time, the 10-Year U.S. Treasury yield bottomed at 2.04% and the 30-Year U.S. Treasury yield fell as low as 2.52%. Today, the 10-Year U.S. Treasury yield is meaningfully lower at 1.70%, yet the 30-Year U.S. Treasury yields remains at a considerably higher level of 2.80%. Thus, the long end of the curve still has a good deal of room to rally based on past precedence alone.

Taking this theme a step further, another point worth noting is that the short end of the Treasury yield curve is substantially lower than it was back in December 2008. Suppose under extreme market stress the current yield curve eventually assumed the same consistency of slope today that we witnessed back in December 2008. Holding the short end of the curve fixed, this outcome is implied by the dashed red line in the chart above. Under such a scenario, this suggests a 30-Year U.S. Treasury yield falling toward the 1.80% range. While this possibility may seem absurd at first glance, it is notable that the Japanese 30-Year Government Bond closed Friday's trading at an even lower yield of 1.74%. So although extreme, it is a shift lower in yields that is not without global precedence.

Thus, despite what has been an exceptionally strong run over the last three decades in general and the last few years in particular, the rally in Long-Term U.S. Treasuries may still have further to run. For if we see the outbreak of another extreme crisis episode in the coming months, investor flight to the relative safety of U.S. Treasuries may drive long-term yields to fresh new lows.

Disclosure: I am long TLT.

Disclaimer: This post is for information purposes only. There are risks involved with investing including loss of principal. Gerring Wealth Management (GWM) makes no explicit or implicit guarantee with respect to performance or the outcome of any investment or projections made by GWM. There is no guarantee that the goals of the strategies discussed by GWM will be met.